Should Investors Be Chasing Strength or Buying Weakness?

NEW YORK (Fabian Capital Management) -- The price action of the market in April has been a perfect example of the risk to reward of buying on weakness rather than chasing strength.

In the beginning of the month, the SPDR S&P 500 ETF (SPY) dipped below its 50-day moving average and appeared to be headed for much lower prices. Fears over further conflict between Russia and Ukraine along with weakness in momentum stocks was enough to push the markets below this key trend line. However, subsequent positive earnings announcements and geopolitical stabilization rapidly shifted the momentum back to the bulls.

We are now trading back to within spitting distance of all-time highs and many investors who are sitting on the sidelines are wondering where the next big move will be. Surprisingly enough, the iShares Transportation Average ETF (IYT) and Energy Select Sector SPDR (XLE) were two of the market leaders during this recent surge higher. Now both sectors have secured breakouts to new highs that warrant caution for investors that are thinking about chasing this strength.

In a liquidity-driven market, there are periods of time when stocks grind higher without giving you the benefit of a pullback to set up a more favorable entry point. Multiple days and weeks of positive returns make it agonizing to sit on the sidelines and patiently wait for a pullback or better trading opportunity.

However, that is oftentimes the best course of action when presented with the alternative of buying the highs and swiftly watching your hard-earned capital evaporate. The psychological nature of investing is that you want to add more exposure when things seem good, which is counterintuitive to buying low and selling high.

In the short term, the market appears overbought and may be presented with resistance at the prior highs. In addition, the seasonality component of the dreaded summer months may provide another level of concern when contemplating the next price cycle. This could lead to increasing bouts of volatility as we saw at the beginning of April, which opportunistic investors can use to their advantage when establishing new positions.

Without a doubt, the long-term trend of stocks is higher and the bull market remains intact. Within that framework, I have a healthy allocation to equities for myself and clients that include both domestic and international exposure using exchange-traded funds.

Right now I am eschewing momentum sectors like biotechnology, solar and social media stocks because of their heightened volatility. Instead, I am focusing on stalwart areas such as dividend-paying stocks, low-volatility equities and other value areas.

Two of my favorite dividend-oriented ETFs are the iShares International Select Dividend ETF (IDV) and First Trust Nasdaq Technology Dividend Fund (TDIV). IDV gives you access to dividend-paying stocks of foreign developed countries while TDIV is focused on domestic technology companies that are returning profits to shareholders.

If you have a healthy dose of cash on the sidelines, I think it makes sense to build out your watch list and look to average into new positions or add to core holdings on weakness. The additional volatility this year should be used to your advantage by purchasing dips of sectors or stocks that have favorable price trends. Buying short-term weakness when the larger technical picture is still intact can improve your chances of a successful investment.

In addition, I always recommend setting a stop loss or using a sell discipline to mitigate the risk of a more protracted decline. There is always a chance that we see a larger-scale pullback that breeds further downside momentum.

The total return of stocks in 2014 has been fairly tepid. However, there have been a number of opportunities for investors to enhance their returns through strategic positioning or tactical purchases. Keep that in mind as we make our way through the remainder of the year.